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Pros& Cons of farm equipment leases

Not that long ago, leasing farm equipment was considered the poor stepchild of acquiring iron. Today, lower farm income and tighter lending requirements have farmers considering leases. If you are looking at leasing, “it’s important that you consider both the pros and cons of this decision and that you consider what effect lease vs. purchase decisions have on the tax return,” warns Tina Barrett, executive director of the Nebraska Farm Business Inc. and an economist with the University of Nebraska.

LEASING CAN BE POSITIVE TO THE BOTTOM LINE

Reducing debt will improve the debt-to-asset ratio for a farm that has equity in assets. See “Example of Balance Sheet Improvement” for an example of how that might work. “We also see improvement in the current ratio and working capital of the operation by removing that current debt from the balance sheet,” Barrett says. “Some lending institutions will include the upcoming lease payment as a current debt, so this pro may depend on the individual.”
Leasing will also keep you from having an asset that depreciates. “Most equipment depreciates rapidly,” Barrett says. “The last few years have certainly been an exception to that generalization, but we are seeing the trend of prices for used equipment dropping again. One argument that is often made in the case for a lease is that you don’t see that depreciation because you don’t own the asset. On the other hand, by not owning, you will never build equity in the asset.”

The importance of this depends on the individual operation’s goals. For example:

A young or beginning farmer may look at leasing equipment as a means to freeing up a leverage ratio to allow equity to be used to purchase land someday.
A small farmer may not have enough acres to spread out the ownership cost of a combine, and leasing could allow the use of a good machine without such a large outlay (although the minimum hour requirements of many leases take this advantage out).
An operation that routinely trades equipment every year or two wouldn’t have built equity in the asset.
TAXES ARE A 
LEASING CON

Most banks that furnish equipment with a lease put taxes at the top of their list of reasons you should lease. However, Barrett points out, “as a tax preparer, I list taxes as the top con.”

Tax law certainly allows that rental or leasing of farm assets is an “ordinary and necessary business expense,” she explains.

It also clearly defines what is not considered a lease but rather a Conditional Sales Contract as defined in the IRS Publication 535 (see “Details on Tax Implications of Leases” below).

“In the leases I see, there are many factors that trip the IRS rules, but the most common is a lease that has a stated or imputed interest value or does not have a true fair-market value buyout schedule in the end,” she says. “In simpler terms, a true lease will not have an equal payment as the buyout, there won’t be a stated interest rate, and you won’t gain any equity in the asset.”

Whenever you move from owning an asset to leasing one, “you have to deal with the sale of the old asset,” Barrett points out.

Even if the dealer allows a trade-in of the value of the owned tractor on the lease of a new one (which pokes further holes in the IRS view of a true lease), it is not a qualified like-kind exchange, because you don’t own the new tractor. This means you will need to recognize the gain on the sale of the old tractor when you dispose of it.

“If you had a tractor with a fair market value of $100,000 and $0 basis assuming you’ve used all the depreciation (likely with the enhanced depreciation that you’ve enjoyed the past few years), you have a $100,000 gain and could easily recognize a $20,000 or higher tax bill as a result,” Barrett says.

NO EQUITY BUILDS

Regardless of the IRS definition of a true lease, there are concerns with never building equity.

“A few types of operations may benefit from having a lease, but there is a long-term downside to never building equity in the major pieces of equipment,” Barrett says. “Operations that can get ahead of the debt load and build equity in equipment will have that net worth and eventually have improved cash flow for not having to make those debt payments.

“When producers ask me whether they should lease or purchase an asset, I evaluate the question based on two purchase options, throwing out the tax benefit of a lease until I find a lease agreement that meets IRS guidelines,” Barrett says.

“I had a producer who had been trading tractors every two years for many years and had recently switched to every year. The sales rep wanted to know what they could do to trade this time,” she says.

Barrett says with this example, the quote was $85 per hour for two tractors that had a combined 1,200 hours or $102,000. The lease option was a two-year commitment. It was $30,000 per year per tractor for 1,200 hours or a total of $60,000 per year. “The producer called me with the tax concern of selling his current tractors and the fact that he wouldn’t be building equity with the lease option,” Barrett recalls. “On the other hand, he was thinking he would be locking in the equity he’d built in his current machines. He had already dismissed the option to purchase, and we discussed the option of not trading at all.”

The producer’s current loan payment was about $50,000, making this option the best for cash flow and for reducing his expenses. Obviously, at some point, equipment needs to be replaced, but now is a great time to reconsider habits built during times of prosperity.

“Understanding the tax implications of any decision is important, but I encourage you to look at what makes the most management sense for your operation.”

Example of Balance Sheet Improvement If you own a tractor that is worth $100,000 and you owe $80,000, you have entries on both sides of your balance sheet. The tractor is listed as an intermediate asset, and the loan is listed in both the intermediate category (the remaining principle balance that is due in more than 12 months) and the current category (the payment that is due in the next 12 months plus any accrued interest), says economist Tina Barrett.

“Let’s assume your total assets with the tractor were $1,100,000 and your total debt was $280,000. Your debt-to-asset ratio would be 25%,” she says. “If you eliminated the tractor, assuming the $20,000 of equity was paid in income taxes (see the Cons section), your new total assets would be $1,000,000, and your new total debt would be $200,000. Now your debt-to-asset ratio is only 20%.”

EXAMPLE OF BALANCE SHEET IMPROVEMENT

If you own a tractor that is worth $100,000 and you owe $80,000, you have entries on both sides of your balance sheet. The tractor is listed as an intermediate asset, and the loan is listed in both the intermediate category (the remaining principle balance that is due in more than 12 months) and the current category (the payment that is due in the next 12 months plus any accrued interest), says economist Tina Barrett.

“Let’s assume your total assets with the tractor were $1,100,000 and your total debt was $280,000. Your debt-to-asset ratio would be 25%,” she says. “If you eliminated the tractor, assuming the $20,000 of equity was paid in income taxes (see the Cons section), your new total assets would be $1,000,000, and your new total debt would be $200,000. Now your debt-to-asset ratio is only 20%.”

DETAILS ON TAX IMPLICATIONS OF LEASES

The following excerpt from the IRS Publication 535 is selected by economist Tina Barrett to explain what is considered a conditional sale contract.

Whether an agreement is a conditional sales contract depends on the intent of the parties. Determine intent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies; however, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true:

The agreement applies part of each payment toward an equity interest you will receive.
You get title to the property after you make a stated amount of required payments.
The amount you must pay to use the property for a short time is a large part of the amount you would pay to get title to the property.
You pay much more than the current fair rental value of the property.
You have an option to buy the property at a nominal price compared with the value of the property when you may exercise the option. Determine this value when you make the agreement.
You have an option to buy the property at a nominal price compared with the total amount you have to pay under the agreement.
The agreement designates part of the payments as interest, or that part is easy to recognize as interest. If a lease agreement meets any of these tests, you are not allowed to deduct the payment as rent. Instead, you need to capitalize the asset as if you had purchased the item.

(Source – http://www.agriculture.com/machinery/machinery-insider/pros-cons-of-farm-equipment-leases)

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